Although the Great Recession of 2007-2008 may technically be over, small businesses are still feeling its effects. Not only are they finding it harder to obtain the necessary financing to fund daily operations or expand, but the overall anemic economy has put a strain on their best customers as well. As a result, there are many small businesses fighting on the verge of bankruptcy. As these businesses continue to struggle, you may find their owners seeking your counsel as they work feverishly to save their company from collapse. Therefore, it is imperative that during this time of continuing economic crisis for many small business owners, the attorneys who counsel them be aware of the owner’s potential personal liability for the unpaid employment taxes of the company.
Unpaid trust fund taxes are an area of potential personal liability for small business owners, which can be imposed regardless of any “corporate veil” protections available under state law. In this time of economic uncertainty for small businesses, it is important for its owners to be aware of this potential liability and take the necessary corrective measures. This article will address: (1) the principle of trust fund taxes, (2) the imposition of personal liability under IRC § 6672 and its state counterparts, (3) how small business owners find themselves liable under these provisions, and (4) what attorneys can do to help.
Employment Taxes. All businesses with employees must pay certain employment taxes to the United States. The most typical taxes paid are Social Security, Medicare, and employee income tax withholding. Traditionally, the Social Security and Medicare taxes are shared equally between the employer and employee. The employer pays half the tax, and the employer withholds the other half from the employee’s paycheck. The employer must also withhold an amount necessary to cover the employee’s income tax as well. All these amounts are then remitted to the IRS through the company’s filing of its employment tax returns. While the company is directly paying its half of the employment taxes, it is also forwarding the employees’ portion withheld on the employees’ behalf.
The Typical Situation. Many small business owners have a general idea of the concept of personal liability protection afforded them as a part of their chosen business entity. This is often one of the only things the owners remember their attorney telling them at the formation meeting. Whether the company was formed as a corporation, limited liability company or limited partnership, small business owners probably understand the idea that their personal assets are generally protected from claims against the company. However, as these owners take their last stand in an attempt to save the company, they might unknowingly subject themselves to personal liability for nonpayment of employment taxes after the company has gone bankrupt. Without appropriate counsel, the small business owner may mistakenly rely on the “corporate veil” protection, not realizing that unpaid employment taxes are a trap into which they might fall.
The situation is fairly typical. A small business may be suffering for some time. As the business declines, so does the available cash to meet the daily operating expenses. The business has more money going out than coming in, so the owners must find unique ways to come up with cash. At that point, owners may stop remitting employment tax withholding as a way to free up some extra cash, paying their suppliers instead. Or the owners, in the final weeks or months of the struggling business, may tap into this cash to fund the daily expenses of the business.
The common rationalization is that, once the business has turned around (or gotten through that particular rough patch), all will be well and the employment taxes will be paid after the business recovers. And if the company does not recover and instead goes bankrupt, the owners simply hope that the tax liability will “go away” in bankruptcy. However, not only do tax liabilities receive priority in the bankruptcy of a business, but the owners will typically become personally liable for a “100-percent” penalty that is equal to the amount of the “trust fund” portion of the unpaid employment taxes. To make matters worse, the personal liability of the owners is not even dischargeable in personal bankruptcy. This liability has the potential to wreak havoc on the owners’ personal finances, and could potentially saddle them with overwhelming personal tax debt for years to come.
Trust Fund Taxes & The Internal Revenue Code (“IRC”). The money a company must withhold from its employees is generally considered the “trust fund” portion of the employment taxes. The basic theory of trust fund taxes is that the company and its owners are retaining the employee’s tax withholdings ‘in trust’ for the benefit of the United States, until such time as the company remits the payments to the government. The money, in essence, never belongs to the company and cannot be used for other business expenses. This theory was codified in IRC § 7501, which states “[w]henever any person is required to collect or withhold any tax from any other person and to pay over such tax to the United States, the amount of tax so collected or withheld shall be held to be a special fund, in trust, for the United States.” This special provision provides the foundation for personal liability of unpaid employment taxes under a constructive trust-type theory.
The Trust Fund Recovery Penalty (“TFRP”). The TFRP statute specifically states:
Any person required to collect, truthfully account for, and pay over any tax imposed by this title who willfully fails to collect such tax, or truthfully account for and pay over such tax, or willfully attempts in any manner to evade or defeat any such tax or the payment thereof, shall in addition to other penalties provided by law, be liable to a penalty equal to the total amount of the tax evaded, or not collected, or not accounted for and paid over.
This key provision places liability for employment taxes not only on the company, but also on those responsible for seeing that such taxes get paid. The purpose of the TFRP according to the Internal Revenue Manual (“IRM”) is to “serve as an alternative means of collecting unpaid trust fund taxes when taxes are not fully collectible from the company business,” and to use such provision as the proverbial stick to “enhance voluntary compliance.”
The TFRP provision has actually been around for some time, with the first instance of the penalty being incorporated in the Revenue Act of 1918. The original law imposed a 100-percent penalty equal to the amount of unpaid tax on “any person who willfully refused to pay, collect or truly account for and pay over” any excise tax. The Social Security Act of 1935 and the Current Tax Payments Act of 1943 both made the 100-percent penalty applicable to the failure to pay employment taxes. Ever since the incorporation of employment taxes into the purview of the TFRP, it has become a key provision in assessing business owners with personal liability for the failure to remit the “trust fund” portion of the company’s employment taxes. While this penalty is civil in nature, the possible potential for criminal liability for the willful failure to pay employment taxes cannot be underestimated. Although outside the scope of this article, and relatively rare in practice, criminal liability is possible and these matters should not be taken lightly.
Civil liability under the TFRP statute can be divided into two main elements. First, who are the person or persons responsible to “collect, truthfully account for, and pay over” the employment taxes of a company; and second, did the responsible person or persons willfully fail to take such action?
Responsible Person. Under IRC § 6671, a “person” includes “an officer or employee of a corporation, or a member or employee of a partnership, who as such officer, employee, or member is under a duty to perform the act.” Since the IRC does not specifically define what makes a person responsible to “collect, truthfully account for, and pay over” employment taxes, it has been left up to the courts to decide. Prevailing authority suggests a responsible person is a person with the “power to control the decision-making process by which the employer corporation allocates funds to other creditors in preference to its withholding tax obligations.”
Under the IRM, the primary factor in determining who are responsible persons centers on the status, duty and authority of such persons to “collect, truthfully account for, and pay over” the employment taxes. The status, duty and authority of such persons are generally determined by their ability to exercise “independent judgment with respect to the financial affairs of the business.” The indicators of independent judgment are: (1) the position as officer, director, or shareholder of the corporation, (2) the ability to hire and fire employees, (3) the exercise of authority to determine which creditors to pay, (4) the responsibility to sign and file employment tax returns, (5) control of payroll and disbursements, (6) control of the corporation’s voting stock, and (7) control of federal tax deposits. To make such a determination, the IRS will usually review the articles of incorporation, minute books, employment tax returns, payroll records, bank records and any other relevant documentation to determine who is a responsible person. Determining responsibility is a factor approach, and therefore, the existence of only one factor (i.e. title as officer, without more) generally is insufficient to show responsibility. The IRS will generally focus on who is listed on the signature card of the bank records as evidence of the person’s ability to control payments.
Willfulness. Once a determination has been made that a person is a “responsible” person, the second inquiry is whether he/she “willfully” failed to “collect, truthfully account for, and pay over the employment taxes.” Willfulness is very broad, but some courts have attempted to define it in the context of a TFRP assessment. In Domanus v. U.S., the Court stated willful means “voluntary, conscious and intentional – as opposed to accidental – decisions not to remit funds properly withheld to the Government.” In Phillips v. U.S., the Court indicated that a person acts willfully when “he permits funds of the corporation to be paid to other creditors when he is aware that withholding taxes due the government have not been paid.” The court also stated that there does not need to be an evil motive or intent to deprive the government of revenue to establish willfulness. In Finley v. U.S., willfulness also includes the failure of a person with authority to investigate or correct mismanagement after being notified that withholding taxes have not been paid.
After the IRS has determined a person is responsible and has willfully failed to collect, truthfully account for, and pay over the employment taxes, then such person or persons become liable for the entire unpaid trust fund portion of those taxes. Since the TFRP applies to “any person,” more than one person could be assessed with the entire TFRP, and will be joint and severally liable. However, the IRS is only allowed to collect once.
Although the determination of a responsible person is highly fact-sensitive, and should ultimately be based on the specific facts and circumstance of each case and not on the person’s title alone, the main targets are typically the officers and directors of the company. For small businesses, the owners are usually also the officers and directors, and typically control (or are ultimately responsible for) the financial matters of the company. In practice, it is relatively difficult to show that an officer or director has no responsibility or authority over the collection, accounting and payment of taxes, unless a division of that responsibility is clearly delineated in the company organizational or operating documents. Therefore, unless the IRS finds anything expressly to the contrary, officers and directors typically find themselves with the requisite “independent judgment with respect to the financial affairs of the business,” especially if their names appear on the check signature cards of the company bank accounts.
It should also be noted, however, that although responsibility is usually imposed on officers and directors, a responsible person can technically also include other employees as well. Therefore, if a non-officer vice president (or even the accounts payable clerk) has sufficient authority to independently make or withhold payments, or otherwise exercise authority, he/she may also be considered a responsible person and subject to personal liability.
Statute of Limitation. Generally, the statute of limitations for bringing tax assessments against a taxpayer is three years after the due date of underling return, or from when the return was filed, whichever is later. However, with regard to employment taxes, the statute of limitations for the IRS to assess the TFRP is “3 years from the succeeding April 15 or from the date the returned was filed, whichever is later. Since employment tax returns are generally filed quarterly, the typical three year statute of limitations can be stretched out into an almost four year statute. For example, the first quarterly employment tax return for a calendar year taxpayer in 2012 was due April 30, 2012. Therefore, the statute of limitations on that return begins on April 15, 2013 and will not expire until April 15, 2016. As such, a small business owner whose company went bankrupt could have potential personally liability for any unpaid employment taxes hanging over him/her for up to four years after the company shut its doors.
Illinois Trust Fund Recovery Penalty Provisions. In addition to the federal TFRP provisions provided in the IRC, Illinois also has a state TFRP counterpart very similar to IRC § 6672. The Personally Liability Penalty (“PLP”) provision of the Illinois Interest and Penalty Act provides that:
Any officer or employee of any taxpayer subject to the provisions of a tax Act administered by the Department who has the control, supervision or responsibility of filing returns and making payment of the amount of any trust tax imposed in accordance with that Act and who willfully fails to file the return or make the payment to the Department or willfully attempts in any other manner to evade or defeat the tax shall be personally liable for a penalty equal to the total amount of tax unpaid by the taxpayer including interest and penalties thereon.
The PLP operates in a very similar manner as the federal TFRP provision, and Illinois courts have tended to apply its legal standard in a similar manner. The PLP provision not only applies to the state employee income tax withholding requirements of the Illinois Income Tax Act, but also extends to other taxes such as sales tax and unemployment insurance.
The PLP has been held to be applicable to the sales tax provisions of the Illinois Retailers Occupation Tax Act. Sales taxes fall under the theory of a “trust fund” tax because they are imposed on the purchaser, yet the seller is charged with the responsibility of collecting and remitting such taxes. As such, the seller is said to be holding the purchaser’s sales tax for the benefit of the Illinois Department of Revenue until such time the amount can be paid over. If a company is in the business of retail sales, sales tax liabilities can be significant, which if not paid, can turn into significant personal liability for its owners.
Personal liability under the PLP for unpaid unemployment insurance is a relatively new provision that has taken effect beginning with reports due for the first quarter of 2012. Such provision can now attach personal liability on officers and directors for the failure to file wage reports and make unemployment insurance contributions to the Illinois Department of Employment Security.
Counseling your Small Business Owners. When counseling your small business clients on the issue, the most important thing to do is to make them aware of the potential for personal liability, and that the “corporate veil” protection of their chosen business entity will not protect them. If small business owners are not aware or do not fully understand this potential liability as they struggle to save their business, they will likely assume all debts will be forgiven in the bankruptcy and may take a “nothing left to lose” attitude towards raiding the employment tax withholdings during the last weeks and months of the business.
One of the best preventive measures to suggest would be the hiring of a payroll service provider. Even if the company only has a few employees, a payroll service provider will generally take care of the necessary withholdings, filings, and remittance of taxes to the government. In that respect, the payroll service provider will remove the temptation to use withholding payments out of the owner’s hands. With the assistance of a payroll company, as long as the employees are paid, so too will the employment taxes be paid.
To the extent there are owners, directors and officers within the company who do not have the authority to pay employment taxes or have access to the financial matters of the company, such limitations should be properly recorded in the company’s formation or operating documents. Such a division of responsibility, if respected in substance, can provide those non-responsible owners, directors and officers with a degree of protection against the assessment of the TFRP. However, to the extent the owners, directors and officers must retain the responsibility for the tax and finances of the company, the hiring of a payroll service provider is an excellent start.
Conclusion. Trust fund taxes can be a significant liability to a company, and if those liabilities are not properly accounted and paid for by the business, the owners can become personally liable for those taxes if the business goes under. Therefore, it is imperative that if you are counseling small businesses, you make your clients aware of this hidden potential personal liability. The owners must be aware that if trust fund taxes are not properly dealt with before bankruptcy, the IRS and Illinois Department of Revenue will come after them personally to recover the amounts owed from the trust fund taxes. The “corporate veil” will not help them here.
 Although Social Security and Medicare taxes are traditionally split equally between the employee and employer, under the Obama payroll tax holiday of 2010, and reauthorization through December 31, 2012, employees are currently paying 2% less than the employer’s portion.
 Employee income tax withholding is not split between employer and employee, but instead completely deducted from the employee’s gross pay.
 IRM 220.127.116.11 (the IRM is the official practices and procedures used by the Internal Revenue Service’s auditors and examiners for guidance during audits and investigations); According to a 2008 Government Accountability Office report, as of September 30, 2007, 1.6 million businesses owed over $58 billion in unpaid federal payroll taxes. GAO-08-617.
 See U.S. v. Gilbert, 266 F.3d 1180 (9th Cir. 2001).
 IRC § 6671 (this provision also includes limited liability companies since an LLC is generally taxed as either a corporation or partnership).
 Godfrey v. U.S,. 748 F.2d 1568, 1575 (Fed. Cir. 1984); White v. U.S., 372 F.2d 513, 516 (Ct. Cl. 1967); Haffa v. U.S., 516 F.2d 931, 936 (7th Cir. 1975).
 Domanus v. U.S., 961 F.2d 1323, 1324 (7th Cir. 1992).
 Phillips v. U.S., 73 F.3d 939, 947 (9th Cir. 1996).
 Finley v. U.S., 123 F.3d 1342 (10th Cir. 1997).
 If more than one individual has been assessed for the same tax liability, and one individual pays more than his/her equal share of the liability, such individual shall have the right to contribution from the other individuals assessed, and may bring suit to enforce contribution. IRC § 6672(d).
 IRM 18.104.22.168.1; IRM 22.214.171.124.1.1
 However, under Policy Statement P-5-60, the IRS has indicated that “non-owner employees of the business entity, who act solely under the dominion and control of others, and who are not in a position to make independent decision on behalf of the business entity, will not be asserted the trust fund recovery penalty.”
 IRM 126.96.36.199; IRC § 6501(b)(2).
 See Dept. of Rev. v. Heartland Investments, Inc., 106 Ill.2d 19, 476 N.E.2d 413 (1985); See also Branson v. Dept. of Rev., 168 Ill.2d 247, 659 N.E.2d 961 (1995).
 35 ILCS 5/701 et seq. (Illinois employer withholding requirements); 35 ILCS 735/3-7(a) (applying the PLP to “any tax Act”); 35 ILCS 5/1002(d) (specific incorporation of ILCS 735/3-7 into the Illinois Income Tax Act).
 Brown v. Zehnder, 1095 Ill.App.3d 1031, 693 N.E.2d 1255 (1st Dist. 1998).
 P.A. 97-621; 820 ILCS 405/2405.
Lawrence J. Gregory, JD, CPA is an attorney with The Gierach Law Firm in Naperville, Illinois. He graduated from Northern Illinois University in 2003 with Bachelor of Science Degrees in Accountancy and Computer Science. He received his Juris Doctor from The John Marshall Law School in 2007, where he was the Managing Editor of the Journal of Computer and Information Law. Lawrence is currently the Vice Chair of the DCBA Tax Law Committee.